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Overview
The Momentum indicator measures the amount that a security's price has changed over a given
time span.
Interpretation
The interpretation of the Momentum indicator is identical to the interpretation of the
Price ROC. Both indicators display the rate-of-change
of a security's price. However, the Price ROC indicator displays the rate-of-change as a
percentage whereas the Momentum indicator displays the rate-of-change as a ratio.
There are basically two ways to use the Momentum indicator:
You can use the Momentum indicator as a trend-following oscillator similar to the
MACD (this is the method I prefer). Buy when the indicator bottoms and turns up and sell
when the indicator peaks and turns down. You may want to plot a short-term
(e.g., 9-period) moving average of the indicator to determine when it is bottoming or
peaking.
If the Momentum indicator reaches extremely high or low values (relative to its
historical values), you should assume a continuation of the current trend. For example, if
the Momentum indicator reaches extremely high values and then turns down, you should assume
prices will probably go still higher. In either case, only trade after prices confirm the
signal generated by the indicator (e.g., if prices peak and turn down, wait for prices to
begin to fall before selling).
You can also use the Momentum indicator as a leading indicator. This method assumes
that market tops are typically identified by a rapid price increase (when everyone expects
prices to go higher) and that market bottoms typically end with rapid price declines (when
everyone wants to get out). This is often the case, but it is also a broad
generalization.
As a market peaks, the Momentum indicator will climb sharply and then fall off--
diverging from the continued upward or sideways movement of the price. Similarly, at a
market bottom, Momentum will drop sharply and then begin to climb well ahead of prices.
Both of these situations result in divergences
between the indicator and prices.
Example
The following chart shows Integrated Circuits and its 12-day Momentum indicator.
Divergences at points "A" and "B" provided leading indications of the reversals that
followed.
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